Which College Accounts to Tap First
My son starts college this fall. Which account should I tap first to help pay the bills: a custodial account, his 529 college-savings plan or a taxable account?
It all depends on your tax situation. If you're eligible for the Hope credit, for instance, you won't want to pay the full tuition bill from the 529 plan because you can't double-dip on income-tax breaks.
You can take the Hope credit if your adjusted gross income for 2008 is less than $116,000 on a joint return (or $58,000 if you're single). In that case, you get a tax credit of up to $1,800 per child for the first two years of college, which lowers your tax bill dollar for dollar. To claim the credit, however, you have to pay at least $2,400 of your bill from an account other than a 529.
After your child's first two years of college, you may qualify for a Lifetime Learning credit of up to $2,000 per tax return. You have to meet the same income requirements as for the Hope credit, plus you have to pay at least $10,000 in college bills from a source other than a 529 plan.
If your income is higher, you might qualify for a tax deduction for tuition and fees (a tax break that has expired but could be revived for 2008 returns). Once again, however, to be eligible you can't pay the entire college bill from a 529 savings account.
After you've maximized your tax breaks -- or if you don't qualify for any -- go ahead and tap your son's 529 plan. Money from that account can be used tax-free to pay for tuition and other qualified college expenses.
From a tax perspective, tapping your son's custodial account becomes a bit dicier. The first $900 of a child's unearned income is tax-free, and the next $900 is taxed at the child's rate -- which is 0% for long-term capital gains and qualified dividends in the bottom two income-tax brackets in 2008, 2009 and 2010. But investment income above $1,800 is taxed at the parents' higher rate -- generally 15% for long-term capital gains. This "kiddie tax" applies to dependents younger than 19 and full-time students younger than 24.
You can lower your tax bill by keeping your child's investment income (including dividends as well as capital gains on the sale of stock or mutual funds) below the $1,800 limit each year as long as your child is still in school. Your son could withdraw the rest of his money, and pay taxes at his own rate, after graduation or age 24, whichever comes first.
Note: Your child needs to be on board with this strategy because he gains control of the custodial account when he reaches the legal age. That's generally 18 or 21, depending on the state.
For more information about the tax breaks for college costs, see IRS Publication Tax Benefits for Education. For more information about 529 college-savings plans, see Everything You Need to Know About 529s.
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